Mutual Fund Mania – Choose wisely during RRSP season!

Usually the first vehicle of choice for new investors is a mutual fund. In days of yore, which in the investment industry is more than five years ago, investors usually bought equity funds but in more recent times balanced funds have grown more popular and even bond funds have attracted money.

Oftentimes, the first mutual fund experience is a disappointing one. There’s a reason for this. People intuitively want to be associated with success, so their first mutual fund will have these characteristics:

  • A great track record of top quartile performance over at least three to five years.
  • Billions of dollars invested in it, so it is “safe.”
  • Offered by an investment firm with a long and “distinguished” history.

Many years ago, there was much less data readily available and few statistical tools at one’s disposal, but I was curious and decided to examine a group of funds over time to see what their performance looked like. What I discovered is represented in the chart. There were no exceptions; every fund in my sample followed this same pattern.

It doesn’t take a mathematician to interpret a picture. If you invest in the fund when it’s a dog (ranks very poorly compared to other funds), the odds are great that given time it will be a top performer soon enough.

The problem is that most investors will pick a top performer. However, the top performer will soon become a dog, and the investor will be unhappy.

A great track record might actually guarantee poor performance.

When it comes to your money, intuition sucks. You “intuitively” steer towards something that “feels good.”

There is enough publicly available data nowadays to help you find a few funds that suit your tastes and examine their performance patterns. What suits your tastes may include funds that are easy to buy in and out of, those you have read about in the press, whose portfolio manager sounds smart on TV, or you may prefer socially responsible funds. When one of the funds that does occasionally perform very well has been in a slump over the past year or two, buy it. After the performance has improved over the course of a couple of years and you’re happy with the results, consider selling (or redeeming) it when the fund is in the top of the rankings (or wins an award) and buy a different fund that is in a temporary slump.

Being a curious sort, I once had the urge to see if award-winning funds followed the same pattern. After all, if someone wants a top-performing fund, wouldn’t they head straight for the ones that have just won awards for their outstanding performance?

I looked at the award-winning funds in any given year, and then checked their performance just one year later. Rather than examine every category (there are just too many nowadays) I stuck to basic Canadian equity, U.S. equity, small cap, international equity. Included were “thematic” funds popular at the time, such as ‘precious metals’ and the ‘dividend and income’ funds. Here are a couple of examples of what I usually found:

Results:

  • 100% of the winners were either 1st or 2nd quartile funds. The next year, 88% of these had fallen to 3rd or 4th quartile.
  • All the former 3rd quartile funds (dogs) rose to 1st quartile (stars) in the following year.

Winning an award (being a top performer) is not an indication of how that fund will rank in terms of its future performance, even in the following year. In fact, the odds are awfully good that your 1st or 2nd quartile pick will be below the median or worse one year later. Interesting! If there’s a lesson, I suppose it’s simply that funds should be bought because they meet your objectives, not because they’ve been performing well recently.

It’s not important to understand why this roller coaster occurs for mutual funds, it just does. Markets change, so, for example, when a growth fund invested primarily in technology stocks suffers, it’s no doubt because the upward trend in technology stocks, or their popularity among the herd, has either stopped or deteriorated. Apple is a prime example in the news right now.

Portfolio managers are just people working for people. I’ve witnessed the following scenario occur time and again:

  • Fund performance begins to soar.
  • Fund attracts lots of new money.
  • Marketing folks want more and more time from portfolio manager for meetings.
  • Money pours into the fund in droves.
  • Portfolio manager’s head swells (the “I’m a genius” syndrome).
  • Performance begins to deteriorate.
  • Money leaves the fund in droves.
  • Portfolio manager has to sell the fund’s best stocks (there are still buyers for these).
  • Performance sucks, and it takes two to three years for things to get back to normal.

Size really doesn’t matter…unless the fund is humongous.

A thinking person should be able to figure out that it doesn’t take a big fund or a big fund company to provide good performing funds. Think about it. Do you shop at the big box stores because the level of service is better? Is the quality of the merchandise better? No. You shop there because the economy of scale for the store allows them to buy products at a lower cost. They can order in bigger volumes and squeeze their suppliers. They then pass these savings to their customers.

Larger financial institutions enjoy similar economies of scale. Of course, the transactions and administration costs of the bank or insurance company are lower, and these benefits might come your way in the form of lower fees and expenses, but we’re not talking about buying lawnmowers. Rates of return on funds managed nimbly and intelligently can make those fees and expenses pale by comparison.

Bigger is safer possibly when you’re banking, but legitimate capital management companies are structured so that they never really touch your money. The custodial (where the money is physically held) and administrative (recordkeeping) functions are usually provided to these firms by big banks or huge financial institutions anyway—for safety and regulatory reasons and it makes the potential for fraud near impossible.

The reason why large financial services companies got into the fund management business was simply economics. They were providing banking, custodial, and administrative services to mutual fund and other asset management companies anyway, so why not also earn management fees by offering their own mutual funds and private wealth management services?

Take it from someone who knows from experience. Managing a massive quantity of money in one fund is much more difficult for a portfolio manager. You can only buy big companies. A portfolio manager will try to buy the best big companies, but since everyone else with big portfolios is doing the same thing, it’s not like you can outsmart them. It’s sort of like playing poker with jacks, queens, and kings being the only cards in the deck. If the three other players see three kings on the table, everyone knows you still have one in your hand.

Applying some discipline is important when directing your savings and will spare you much grief. For several years since the financial crisis, investors have swarmed into bond (see chart – it shows the net Sales of bond mutual funds) and balanced funds because of their strong relative performance and are considered to be less risky. Even today buying into income-oriented funds ‘feels good’ – everyone else is doing it, past performance is good and the fright we all experienced during the financial crisis still stings a bit.

Equity funds have been avoided for years – constantly redeemed – despite the fact the stock market returns have been outstanding since the crisis more or less ended (or at least stabilized). Now that the past returns are looking better, investors will be shifting money out of the bond funds (and perhaps balanced funds as well) and chasing the top performing equity funds.

This is an inferior strategy. If you examine the best ‘rated’ funds you will find they hold more dividend paying and income securities and will likely drop in the rankings very soon after you buy them.

With RRSP season comes a plethora of marketing campaigns and firms will be pushing us to buy their best performing funds (we are so quick to buy what ‘feels good’). Since you won’t see many advertisements for those not doing so well today, but are likely to do very well tomorrow, it would be wise to do a bit of homework before buying in. Good luck!

Mal Spooner

 

 

 

Finding an investment adviser is no easy task!

 

When RRSP season rolls around, it’s not unusual for dissatisfied clients to consider firing their investment adviser and finding a new one.  Even though most of the time it’s the client who’s the problem and not the adviser (more about this later), once the decision is made the question is how to select a new adviser?

Out of the several thousand investment advisers and financial planners I’ve met over the years, at least a few ‘hundred’ have what I consider to be the savvy to do an excellent job for their clients.  If only 10% of potential advisers are exceptional, finding one will require some work.  Ideally some of what follows will make the job a bit easier for some.

The most important thing to remember is that a capable stockbroker or financial planner doesn’t have to meet the stereotype.  For example, I was looking to hire a new sales rep for my fund company and received a resume from a fellow who was actually an investment adviser looking for a change.   I arranged to meet with him, and just happened to be standing on the street in front of our building when this black BMW pulls up, and a jittery youngster (young compared to me anyway) gets out.  He has his hair gelled straight back like Gordon Gekko, the fictional bigwig from the movie Wall Street, wearing the well-tailored pinstripe suit complete with suspenders that weren’t really necessary.  I didn’t hire him.

Beware of those advisers that are into role-playing.   It is okay I suppose to have a nice car, but a ‘look-at-me’ aura is a warning sign.  When someone deliberately adorns the trappings of success, I believe there’s insecurity in their personality.  Certainly your adviser should exude confidence but shouldn’t need or want to stand out from the crowd by adorning themselves with accoutrements.

You must be realistic.  Your adviser does work for a financial services firm, so expect to be using products and services offered by his company.  However any evidence that he/she is willing to deviate from the company’s party line for your benefit is a very good sign.

Ask him/her what he/she thinks about the market or a mutual fund, or even an individual stock or two.  If he/she simply regurgitates the newspaper headlines or is in love with a top performing mutual fund (you can’t ‘eat’ past performance is one of my favorite expressions), or his/her favourite stocks are everyone else’s favourite stocks too, you might want to avoid this adviser.  On the other hand, if you sense a real independent thinker willing to disagree with conventional wisdom, the adviser is a keeper.

Larger firms are especially good at marketing their wares, and I would recommend that it is infinitely better that you look for the right adviser rather than to just agree to hire the one that lands on your doorstep.  Keep in mind that good investment managers are not always good with people.  A good first impression is not necessarily an indication that the adviser does good work. Ask questions.  For example, ask exactly how they handled themselves in the financial crisis?

Even though it is extremely difficult (likely impossible) to predict market declines, anyone can certainly “do something” about their circumstances once the proverbial poop hits the fan.  Investment professionals often respond differently depending upon depth of experience or temperament:

  • Some are no more experienced (or no smarter) than their clients – they panic and sell at the bottom of markets.
  • Some proclaim a new respect for caution, and hold more cash and bonds….after it’s too late.
  • Some boldly acknowledge they didn’t see the Bear Market coming, apologize and admit that they are buying cheap assets aggressively ‘near’ the bottom (a good sign indeed).

Asking tough questions will enable you to determine whether you’re talking to a pro.  Don’t be afraid to sound stupid – it’s your money we’re talking about here and not your ego.

You may want to stay with the big firm you’re banking with for convenience, or choose to find a smaller firm that is more specialized in managing money for individuals.  It is much easier to learn about what motivates the professionals in a smaller wealth management boutique, learn about their investment philosophy and get personal attention.

Heads up!  When a firm’s performance presented to you seems too good to be true; it probably is.  A prime example was the case of Bernie Madoff.

In March 2009, Madoff pleaded guilty to 11 federal crimes and admitted to turning his wealth management business into a massive Ponzi scheme that defrauded thousands of investors out of billions of dollars. Madoff said he began the Ponzi scheme in the early 1990s. However, federal investigators believe the fraud began as early as the 1980s, and the investment operation may never have been legitimate.

Even small wealth management companies ordinarily have their performance numbers calculated and audited by third party services.  Make sure any performance data you see has been vetted by an independent third party.  Although instances of fraud get volumes of press coverage, they are one in millions.

Most boutique investment firms aren’t gifted marketers, and they rely heavily upon word-of-mouth to get new clients.  Ask friends, your accountant or lawyer for referrals.  There’s no harm calling and arranging to visit a few firms.

Tips:

  1. Never hire a Wealth Management firm based only on past performance.
  2. Don’t complain about investment results.  Ask for an explanation.
  3. Never second guess your adviser.
  4. Pay the fees – sure hey hurt when performance is poor, but you won’t care at all when performance is good.
  5. Be patient. Good things don’t happen overnight or every day.

Don’t pretend to be smarter than your adviser, you’re not!  Tips number 2 and 3 are very important.  I mentioned earlier that oftentimes the client is the problem, not the adviser.  In times of stress, we have a tendency to let our emotions get the better of us.  It’s kind of like swimming – if you panic then you’re more likely to drown.  Your investment adviser cannot walk on water, but is trained to swim.  There is an infinite number of things that can and do damage investment portfolios. The most damaging crises cannot generally be controlled, but wealth can be salvaged and even restored if level heads prevail.  Click on the picture to watch a funny video I made – are you at all like this client?

 

Mal Spooner

And a Happy New Year to all!

, T-bnAs we finally close 2012, there are many things on which we can reflect. The sad, the inexplicable, the disappointing and yes, some good things too – from an investment perspective anyway!

Canadian banks and other financial institutions, despite a credit downgrade late in the year, are among the safest in the world and investors continue to benefit from holding their preferred shares, common stocks and various debt instruments. The same appears true for the utility industry, despite the contretemps of the Northern Gateway (or maybe Arctic Gateway or Eastern Gateway) oil pipeline in Canada and the US side of the Canada/US Keystone XL pipeline project. Oil is a key utility input in all of it’s many forms as is natural gas. I will stay out of the debate on fracking!

The world needs power – from any and all sources so I believe that for long-term holdings, exposure to this part of the economy is important. Short-term, be prepared for some storms in all of the energy sector, and I suspect they will all be of a political making. So some inclusion of energy and utlities makes some sense – the amount you include depends on your investment comfort level and time-horizon.

Communications in all of it’s forms will continue to grow although I suspect it too will be choppy due to anti-trust, patent issues and regulatory meddling on one level or another. Manufacturing and transportation industries should experience reasonable grow as I believe that deficit and national debts will gradually be controlled allowing economies to begin expanding again.

Whether doing your equities on a do-it-yourself basis or using some form of managed funds or ETFs, I would be staying blue-chip common shares and preferreds particularly for the risk-adverse.

Short-term interest rates (10 years and less), I believe will stay within about 1% to 1.5% of curent levels, which is positive for everyone including companies loooking to expand their operations. If doing things on your own, I recommend GIC or GIA ladders and if you are going the managed fund or ETF route, then I would be looking at average term-to-maturity south of 10 years and only A or better ratings – BBB if you feel adventurous.

On the pure cash side of things, whether in a bank account, T-bill account or some life insurance cash values, it seems to make sense to hold somewhere in the 5% to 7% range – both for protection and any buying opportunities that present themselves.

On Precious Metals – flip a coin! From everything I can find, the “experts” are about evenly divided on direction and potential upside/downside movement. Some level of exposure would seem reasonable if you can tolerate the earthquake-style market reactions but for these I would personally stay on the managed money side and look for broad diversification across countries keeping in mind political situations and I wouldn’t be comfortable holding more than 4% to 5% and only then if I was looking in the 10 plus-year holding range.

Think positive about yourself and your family, keep personal debts going DOWN and by wise in your discretionary spending in 2013!

Sex and the January Effect!

A perplexing phenomenon for money managers and academics alike is the so-called “January effect.”  Also known as the small-cap effect it generally refers to the fact that January tends to be a pretty good month for the stocks of smaller companies.  Despite efforts to come up with an explanation – window dressing by institutional investors, tax-loss selling and so forth – there seems to be no rational reason for the superior performance of these smaller company stocks early in every new year.  Before devling into my own radical theory, is this a real or mythical phenomenon?

Personally, I’ve bet on this phenomenon over many years – loading up the mutual funds I’ve managed with smaller companies during December that I considered inexpensive (their share prices were beaten up for any number of reasons).  The strong January investment performance would often put my portfolio in the top rankings for several months into the new year.  Always good for business.  I’d also encourage clients to buy our specialty fund that concentrated on smaller growth companies in early January, and hold it for a few months to capture the excess return.  It simply worked.

Experiencing or just believing in the effect is one thing, but does the data support the myth?  There are many studies confirming the anomaly.  I found the adjacent chart illustrating that in in January the smallest publicly traded companies indeed do better than the bigger companies.

“From 1926 through 2002, the smallest 10% of all stocks (or “10th decile”) beat the 1st decile stocks by an average of 9.35 percentage points in the month of January.”

Despite repeated efforts to explain why there is a January Effect, everyone agrees that it still remains pretty much a mystery.  Academics refer to such patterns as ‘anomalies.’  My own belief is that there are many instances when statistical observations are better explained by human behavior rather than analytics.

Ever notice that most babies are born in August and September?  Biologically speaking, this would suggest that our species do tend to act somewhat differently nine months prior to these births every year.  During the festive season there’s a whole lot of warm and fuzzy feelings that seem to influence our behavior.  In some cultures there’s a surge in indulgences – food and wine for instance – and for a brief couple of months stress and fear are reduced signficantly.  How do we respond?

Clearly we are inclined to be more intimate.  Couples (if you’ve been married for awhile you’ll understand this) successfully avoid romantic activity for most of the year; bored with their partners or simply turned off by their annoying habits and personality flaws.  Suddenly during the holidays we set aside our grievances and become more tolerant. Those quirks might even seem endearing for a brief period.  Perhaps in the northern hemisphere humans are genetically engineered to seek warmth and comfort during the colder winter months?

 Consider these cold hard facts:

  • We are more than willing to be intimate (hence the birthrate 9 months later) despite the risks – being asked to do more chores and the inevitable burden of an increased level of conversation.
  • During these months we spend recklessly on family and friends who don’t need the consumer items and in some cases don’t deserve them.
  • People drink more alcohol than they should and eat food that is bad for them.

Why wouldn’t the perennial change in our emotional makeup also have an impact on our investment decisions?  My theory is that once a year risk aversion takes a brief backseat in our psyche – and while our hearts and wallets are open why not take some free-spirited risk in the stock market?  Collectively hoping for a big score in those smaller company stocks that occasionally pay big, we all dive in together and cause their prices to rise.

The evidence of humanity’s willingness to take on more risk in the bedroom during the holidays becomes evident nine months later.  And it should come as no surprise that the financial consequences of investment decisions made in a fit of euphoria during the holiday season also show up by September of most every year also.  September is pretty much always the worst month for those stocks bought earlier in the year – small and large companies alike.

I certainly hope you had a good laugh reading my theory explaining the mysterious January effect.  In my opinion it is certainly as good as the explanations you’ll read in the media.  Truth is there is much we’ll never understand about so-called ‘anomalies’ whether they occur in financial markets or in human behavior.  Simply knowing they do occur however can be a powerful tool when making one’s own investment decisions.  Come to think about it, just knowing about some behavioral anomalies might also help when it comes to family planning.

Best wishes to you for a Happy Holiday!

Malvin Spooner.

 

 

Banks own the investment industry! A good thing?

Let’s face it!  In the battle for investment dollars the Canadian banks are clearly the winners!  Is this a good thing?

Once upon a time, the investment business was more of a cottage industry.  Portfolio manager and investment broker were ‘professions’ rather than jobs.  Smaller independent firms specialized in looking after their clients’ savings.  There were no investment ‘products.’  The landscape began to change dramatically – in 1988 RBC bought Dominion Securities, CIBC bought Wood Gundy and so on – when the banks decided to diversify away from lending and began their move into investment banking, wealth management and mutual funds.

Take mutual funds for example.  Over the past few decades Canadian banks have continued to grow their share of total mutual fund sales* – this should not surprising since by acquisition and organic growth in their wealth management divisions they now own the lion’s share of the distribution networks (bank branches, brokerage firms, online trading).

An added strategic advantage most recently has been the capability of the banks to successfully market fixed income funds since the financial crisis. Risk averse investors want to preserve their capital and have embraced bond and money market funds as well as balanced funds while eschewing equity funds altogether. With waning fund flows into stock markets, how can equity valuations rise?  It’s a self-fulfilling prophecy.

Many of the independent fund companies, born decades ago during times when bonds performed badly (inflation, rising interest rates) and stocks were the flavor of the day, continue to focus on their superior equity management expertise.  Unfortunately for the past few years they are marketing that capability to a disinterested investing public.

The loss in market share* of the independent fund companies to the banks continues unabated. Regulatory trends also make it increasingly difficult for the independent fund companies to compete.  Distribution networks nowadays (brokers, financial planners) require a huge and costly infrastructure to meet compliance rules.  Perhaps I’m oversimplifying, but once a financial institution has invested huge money in such a platform does it make sense to then encourage its investment advisers and planners to use third party funds?  Not really! Why not insist either explicitly (approved lists) or implicitly (higher commissions or other incentives) that the bank’s own funds be used?

Stricter compliance has made it extremely difficult for investment advisers to do what they used to do, i.e. pick individual stocks and bonds.  In Canada, regulators have made putting clients into mutual funds more of a burden in recent years.

To a significant degree, mutual fund regulations have contributed to the rapid growth of ETF’s (Exchange-Traded Funds).    An adviser will be confronted by a mountain of paperwork if he recommends a stock – suitability, risk, know-your-client rules) or even a mutual fund.  An ETF is less risky than a stock, and can be purchased and sold more readily in client accounts by trading them in the stock markets.  Independent fund companies that introduced the first ETF’s did well enough for a time but not surprisingly the banks are quickly responding by introducing their own exchange-traded funds.  For example:

TORONTO, ONTARIO–(Marketwire – Nov. 20, 2012) – BMO Asset Management Inc. (BMO AM) today introduced four new funds to its Exchange Traded Fund (ETF)* product suite.

In fact, the new ETF’s launched by Bank of Montreal grew 48.3% in 2011.  When it comes to the investment fund industry, go big or go home!  You’d think that Claymore Investment’s ETF’s would have it made with over $6 Billion in assets under management (AUM) but alas the company was recently bought by Blackrock, the largest money manager in the world with $29 Billion under management.  It will be interesting to see if the likes of Blackrock will have staying power in Canada against the banks.  After all RBC has total bank assets twenty-five times that figure.  Survival in the business of investment funds, and perhaps wealth management in general depends on the beneficence of the Big Five.

Admittedly, the foray of insurance companies  into the investment industry has been aggressive and successful for the most part.  With distribution capability and scale they certainly can compete, but the banks have a huge head start.  Most insurance companies are only beginning to build out their wealth management divisions.  I can see a logical fit between insurance and investments from a financial planning perspective, but then the banks know this and have already begun to encroach on the insurance side of the equation.  Nevertheless I would not discount the ability of the insurance companies to capture signficant market share.

So, is it a good thing that larger financial institutions own the investment industry?  Consider the world of medicine.  No doubt a seasoned general practitioner will feel nostalgic for days gone by when patients viewed them as experts and trusted their every judgement.  The owner of the corner hardware store no doubt holds fond memories of those days before the coming of Home Depot.  Part of me wants to believe that investors were better served before the banks stampeded into the industry but I’d just be fooling myself.  Although consolidation has resulted in fewer but more powerful industry leaders, the truth is that never before have investors had so wide an array of choices.  Hospitals today are filled with medical specialists, while banks and insurance companies too are bursting at the seams with financial specialists.

It is not fun becoming a dinosaur, but this general practitioner has to admit progress is unstoppable.

Malvin Spooner

 

 

 

 

 

 

 

 

*The industry charts are courtesy of the third quarter Scotiabank research report Mutual Fund Review.  The annotations are my own.